CHAPTER 12
The Significance (or Lack of Significance) of Market Performance*
Market Performance and the Character of a Portfolio
Market Performance of Portfolios versus Individual Securities
Outsiders, Insiders, and Market Price
Professional Money Managers and Beating the Market
Perspective on Bailouts and the Significance of Market Performance
There is a common belief among many stockholders and lawyers and much of the judiciary that stock market prices are the one realistic measure of value, and that the only way to tell how an investor is doing is by valuing his securities portfolio from time to time, even daily, based on stock market prices. As discussed in Chapter 3, this is the substantive consolidation view of the world. Common sense tells us that this approach heavily distorts the facts of life because market prices are considerably less important to some security holders and some companies than they are to others.
For stock traders, there are realistic reasons for making stock market prices the only consideration. At the other extreme, for investors interested only in secure income, weight to market should be zero or on occasion even negative, because even though an investor has an ownership position in a credit or a common stock, it is conceivable that he would obtain more benefits from short-term declining prices than from steady or rising market prices. In gauging investment results for the vast majority of people and institutions, market performance at any moment should be given a weight of considerably more than zero and something quite a bit less than 100 percent. The precise weight, assuming that any precision is desirable or even necessary, should be determined by the individual investor.
The concept of weight to different elements of value may have originated in Delaware appraisal proceedings, where stockholders dissented from a merger or similar proceeding. In the now outmoded Delaware block valuation methodology, three elements of value—market value, earnings or investment value, and asset value—were determined, and separate weights were assigned to each of the three elements, with weight for all three elements totaling 100 percent. Through the determination of the three elements, each separately weighted, an ultimate value was determined. In the Weinberger decision1 the court rejected this practice, holding that a proper valuation approach “must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.” The more liberal approach mandated by the Weinberger court led the Delaware courts to consider a much broader array of factors in determining the fair value of a target corporation’s stock.
Market performance as a gauge of how an investor is doing deserves 100 percent weight when the particular investor does not know anything about the company in which he is investing other than the most superficial stock market statistics, such as market price history, recent earnings, dividend rate, stock- ticker symbol, alleged sponsors and the latest popular “story.” It also deserves 100 percent weight when the investor’s financial and/or personal position is such that he is vitally affected, or he believes he is vitally affected, by short-term market fluctuations. One hundred percent weight to market also seems appropriate for sudden death securities; that is, issues where at a certain date, key events will occur as when an option expires, a tender offer concludes, or a merger transaction is consummated. Such people or situations, call for instant performance. Items that are perceived to be critical are inside information about corporate events that they believe will have market impact; technical systems that they believe will assist in forecasting general market trends and individual stock price movements; and trading information that can either be reacted to or used. Perhaps the most traumatic and significant event for this group is to see stocks go down, or even in some instances to see stocks fail to go up. Thus, there is a good rationale for their credos, Don’t let your losses run, and get out of stocks that are not moving.2
To us, it seems foolish to accept the short-term needs cited in the previous paragraph as the norm for purposes of promulgating various securities regulations and accounting rules, yet some of these rules and regulations seem directed strictly toward the desires and needs of those who think day-to-day market prices are all-important.
Many market participants, of course, do not weight stock market price as being of 100 percent importance or even anything close to it. Examples of investment groups that are either indifferent to market price fluctuations or hopeful that they will go down on occasion include individual stockholders who would benefit from low market valuations for, say, estate tax or personal-property tax purposes; investors who are primarily interested in maximizing their cash returns and/or continually creating cash for new investment from noninvestment sources; and those desiring to accumulate large positions, either to exercise control or to influence control shareholders.
It is our view that very few outside investors ought to endow short-run market performance with an all-consuming importance. First, for many, performance has to take a back seat to other considerations in terms of realizing such objectives as the creation of a reasonably well-assured regular cash income from interest and dividend payments. Second, for those following the fundamental finance approach, rarely if ever is emphasis given to short-run considerations. Frequently, timing as to when something will happen is indeterminate when securities appear attractive under our approach: Its four basic elements give no clues whatsoever to what near-term market performance might be like.3 Finally, the studies that are part of modern capital theory indicate that those who attempt to beat the market continuously do not usually do so when beating the market is defined as having a total return on a market risk-adjusted basis in excess of stock market averages.
We agree with the modern capital theorists that it is a losing exercise for almost all outside investors to try to beat the market by forecasting price movements over any particular length of time, say within the next year. To us, it is true in a perverse way that one cannot beat the market by trying to beat the market. Rather, superior long-term performance comes about by indirection—for example, by buying good values as determined under the fundamental finance approach, and sticking with those holdings in the absence of clear-cut evidence that a significant mistake has been made. Evidence of such mistakes will be found in the results achieved by the business rather than in the price of the business’s securities, which at any moment may or may not reflect business reality.
MARKET PERFORMANCE AND THE CHARACTER OF A PORTFOLIO
The importance of market performance depends in part on the character of a portfolio, and other things being equal, market performance will be more important when a portfolio is of a fixed size or subject to net withdrawals of cash, as compared with a portfolio that is the continual recipient of new cash to invest. This latter portfolio is in the nature of a dollar averager, and provided that it consists of sound securities, market performance need not be an overriding consideration. Here, poor past performance means, at least in great part, that present purchases are being made on more attractive terms than in the past, whereas good past performances may spell less attractive current purchases if the underlying value of the security has not increased as much as the price of the security during the interim.
It should be noted, too, that dollar averaging diminishes the need to beat inflation, because changes in the value of money probably will, in the long run, be offset by changes in the returns on securities. This was particularly true during the fifteen years preceding 1978, when inflation was accompanied by rising interest rates. Cash that could have been invested in commercial paper to return 4 percent in 1964 could be invested the same way to return over 10 percent in 1974 and again in 1978. Cash returns available to such investors increased considerably more than did the cost of living. Among the beneficiaries from such inflation-cum-interest-rate developments were permanent investors in high-grade debt securities, provided new funds were being made available regularly for investment and reinvestment. Such investors included many young people with rising salaries and savings, as well as various types of insurance companies and pension plans. The opposite seems true in 2012. Because interest rates are at historic lows, new funds have to be invested for total return, not cash return.
The typical well-run property and casualty insurance company is, in part, an example of a dollar-averaging investor. Its performance is measured essentially by its net investment income—income from dividends and interest after all investment expenses except taxes. The insurance company’s investment departments normally receive continuous new injections of cash from the underwriting departments, growing out of increases in premium volume and, it is hoped, from underwriting profits. For such companies, as long as interest is not defaulted and dividend rates on securities held in portfolios are not reduced or eliminated, the lower the market value of the portfolio, the higher the returns that will be earned on the new funds being invested. And the higher the returns, the faster net investment income will increase. Property and casualty investment departments do have some interest in upward market performance on individual securities, since managements prefer the securities they own to rise in price and the new money to be invested in debt or equities that are available at attractive prices. But as long as the business is adequately capitalized, such considerations are distinctly secondary to the primary purposes of the portfolios—the protection of the policyholder. That tends to restrict investments to generally recognized high-quality securities that are marketable, and to the creation of net investment income.
As a matter of fact, it was the continuing declines in the market value of portfolios of bonds and mortgages that made up the bulk of life insurance portfolios (since interest rates were on a generally rising trend) that contributed importantly toward making life insurance stocks, in general, one of the outstanding growth investments in the 20 years after World War II. Had the market value of their portfolios not been declining, the increases in investment income would have been much slower than was actually the case.
It is true that some insurance companies tend to be harmed in bear markets because their capital adequacy is measured by regulatory authorities on a basis that values common stocks at market. This is normally not a problem for insurance companies since the vast majority of their investments are in performing loans. Huge increases in net investment income arising out of new money being employed for high cash return cannot, in these cases, compensate for capital inadequacy. Nonetheless, the normal economic desires of such investors are that weight to market will be considerably less than 100 percent almost all the time.
MARKET PERFORMANCE OF PORTFOLIOS VERSUS INDIVIDUAL SECURITIES
Market performance is a much more important gauge of investment results for a whole portfolio of marketable securities than it is for an individual security. For example, consider an investment program in unsponsored, special situations where the portfolio companies have high credit worthiness and where securities are selling at prices substantially (say, 50 percent or more) below what the companies would be worth as private corporations. At any one time there might be three to five such securities in a portfolio. The precise timing as to when any one of these securities might enjoy substantial price appreciation is indeterminate. However, if over a period of, say, six months to a year none of these securities appreciates even in a generally declining market, it is fair to conclude that investment results are poor. But the poor results would be attributable more to poor analysis (that is, the securities were not really attractively priced in the first place) than to other factors that explain poor performance for general market securities portfolios, such as weak general market conditions or an uncertain economic outlook.
The one time when market performance of portfolios that are attractive by fundamental finance standards seems bound to be poor compared with the general market, no matter how good the analysis of the securities, is during periods of raging bull markets in speculative-grade growth stocks, such as occurred from 1961 to 1962, in 1968, and in the late 1990s. Even in this situation, though, workout portfolios still should show at least fair returns—say, not less than 10 percent—on the market values of the funds invested.
It is important to note that one of the reasons outside passive minority investors (OPMIs) using our approach cannot give large weight to near-term market performance is that the factors that frequently will have greatest near-term market impact are not what the investor believes alters the fundamental outlook for the company in which he has invested. These factors, which he may not deem particularly important but which are likely to have a strong, immediate market impact, include the following:
In considering the weight that should be given to stock market prices, it is important to remember that a stock market price is not business or corporate value, but a realization value based on the price at which a common stock could be sold in an OPMI market. Therefore, market value as a realization figure is a very realistic figure for a shareholder who owns, say, 1,000 shares of JPMorgan Chase & Co. common selling at 35. However, it does not follow that 35 represents a realistic value for the entire JPMorgan Chase common shares outstanding. There is no way other than in a merger or acquisition that all the JPMorgan Chase shares can be sold on the market for 35 a share or any other price. Thus, statements about an individual’s present worth, obtained by multiplying his holdings by the quoted market value of his stock, have limited operational meaning in many contexts. Market mathematicians may multiply numbers together, but frequently there is a difference between what the numbers are and what they mean.
OUTSIDERS, INSIDERS, AND MARKET PRICE
Indeed, for most investors, market performance as an element in measuring true investment results should have a weight of less than 100 percent. An outsider holding a completely marketable security of a company with a perpetual life should give weight of close to zero to market performance whenever he knows or has reason to believe that the security’s real worth is not closely related to current market prices, and when he knows that he will neither need to liquidate in the near future nor to use the security owned as collateral for borrowings.
There is a school of thought that seems to hold that outside investors with that degree of certainty about investments in companies over which they have no control are bound to be unsuccessful—that the real world just never justifies so much confidence in a security. We disagree.
EXAMPLE
It appears that many of the most successful outside investments have resulted from having such confidence, whether it was by buying and holding General Motors common through the 1933 decline, or by acquiring Japanese insurance stocks at the depth of that country’s extremely sharp business recession and stock market crash of 1965, or even by buying such Japanese securities in 1970 after they had doubled, or Xerox and Holiday Inn when they were emerging securities, or Chicago Northwest Railway and Berkshire Hathaway when they were workout situations, or deep-discount, high-yield, medium-grade bonds in 1974, or Apple Computer when Steve Jobs resumed leadership of the company in 1997.
For insiders and quasi-insiders, as their security holdings become less marketable because of restrictions on sale or otherwise, and as they attain positions in which they can exercise control over a corporation’s affairs, market price tends to become less important than the fundamentals of the business. The purchasers of F. & M. Schaefer Corporation “restricted” common in 1968 at $1 per share (see Chapter 27) did have an interest in the market price of Schaefer common stock after the company went public, and many obviously had to be pleased when the market price climbed to 59 in 1970. Yet what was happening to the business was far more important to them. For them, the key factor in 1970 was not the outstanding market performance of the common stock, but evidence of sluggish corporate performance because of competition from national beer brands. The high price of Schaefer stock would have been useful to these bargain purchasers in a nonpsychological sense only if they could realize something based on those prices by selling their stock, even at a discount from market (they did not and most could not), or if Schaefer Corporation used the high price to issue more equity securities, either to get cash into the company or to acquire earnings properties.
PROFESSIONAL MONEY MANAGERS AND BEATING THE MARKET
Certain economists believe strongly that the goal of professional money managers is to beat the market.4 If professional money managers fail to beat the market either individually or en masse, this is taken as evidence that they are useless. Indeed, it is stated that the outside investor does best by investing only in Index Funds or Index exchange-traded funds (ETFs)—that is, unmanaged companies whose portfolios equal the Dow-Jones Industrial Average or Standard and Poor’s 500 Stock Index.
The kindest word we have for this point of view is that it is amateurish. First, it ought to be obvious that the vast majority of professional money managers have fiduciary obligations that require them to do much more than beat the market. Among those duties are maintenance of cash income and cash principal. Is it important that a strongly capitalized insurance company outperform the market even though its net investment income is increasing at a compounded rate of 10 percent a year and even though in no instance had interest payments been passed or dividends cut or omitted on any security in the company’s portfolio? We think not. The prime goal of the insurance company’s professional money manager is, of course, cash income, not market performance.
Many economists also go one step further and say that there is no need for Securities and Exchange Commission disclosures and other investor protections. This viewpoint fails to observe the obvious. By and large, securities markets in the United States have been healthier during the past 80 years that the SEC has been in existence than ever before. Also, financial analysis has become more important. Furthermore, the quality of securities has gone up, at least as measured by the ability of issuers to provide securities holders with cash returns, that is, payments of interest and dividends. Would this be the case if there were no professional money managers and no SEC? Who knows? Perhaps if the environment were what these economists recommend, the Dow Jones Industrials in mid-2012 would be closer to 5,000 than to 13,000. But if it were 5,000, the average portfolio of marketable securities would have a market performance about average—the same as now.
In summary, it is important to note that the importance to be given to market performance or total return varies from situation to situation. Sometimes total return is all-important to an outside investor; in other instances, it is hardly of any moment. Unfortunately, many scholars and jurists tend to give market performance the same weight for all investments that it deserves in trading situations—100 percent. This unthinking emphasis is particularly unfortunate, partly because it gives stock market prices an emphasis that almost no one operating a business agrees with, and partly because it seems to foster attempts to beat the market on a relatively continuous basis—something most outside investors will never be able to do.
PERSPECTIVE ON BAILOUTS AND THE SIGNIFICANCE OF MARKET PERFORMANCE
In a meaningful sense, everyone who invests in a security seeks a return, or bailout, on that investment. Most of the time, bailout refers to the realization of cash benefits, but this is not so in one case—when ownership of a security results in obtaining various benefits associated with control of companies. Bailouts take many forms, only one of which is an ability to sell, or marketability. Insofar as other forms of bailout are unavailable, marketability and therefore market performance become increasingly important. And insofar as alternative bailouts are available, the significance of market performance diminishes. These other forms of bailout, which have already been discussed in Chapter 4, encompass cash payments to securities holders by the issuer itself.
Holders of debt instruments have a contractual right to receive periodic interest income and eventual return of principal; therefore, cash bailouts tend to be far more assured for them than for holders of common stocks. Accordingly, marketability tends to be significantly less important for a bond than for a common stock. Indeed, most long-term debt instruments, such as many of the tax-free obligations of municipalities, private placements held by life insurance companies, and most mortgage loans held by various types of institutional investors, are probably not marketable at all. This difference in the significance of marketability between debt and equity is even recognized in certain regulatory areas: insurance regulations require that debt holdings that are not available for sale be carried on the company’s books for statutory purposes at amortized cost, whereas common stocks are usually carried at market.
Insofar as common stock ownership represents control, the importance of market performance and marketability tends to be diminished significantly. Control usually allows for two types of bailouts: first, cash bailouts through the ability to control dividend policy and to obtain salaries and fees; and second, nonmonetary bailouts through the ability of controllers to create for themselves one or more benefits that can be described as part of the three Ps—power, prestige, and perquisites.
In addition, there are many stockholders who buy dividend-paying stocks and whose primary objective is income. As a matter of fact, many hold utility common stocks on the theory that present dividend rates are safe and indeed are likely to be increased periodically. To these holders, market bailouts are not important, and they view their holdings in much the same way as do holders of debt instruments, with the essential difference that such common stockholders perceive themselves as holding a “bond” on which “interest” payments are to be increased periodically. To such holders, market performance tends to be a minor consideration.
In contrast, there are security holders for whom market price tends to assume paramount importance, because market is where such holders are seeking their bailouts. These types of security holders fall into four general categories. The first is the common stockholder holding minority interests in which dividend income is either insignificant or not part of the holder’s investment objectives. The second type is the control stockholder and company seeking to sell securities or to issue them in merger and acquisition transactions. Third is the holder who does not have a strong financial position, especially the outside investor or trader who has borrowed or intends to borrow heavily to finance his portfolio. The fourth is the not very well informed trader who makes decisions based on technical market factors rather than underlying knowledge about a company and the securities it issues.
SUMMARY
There is a common belief among many stockholders, lawyers, and much of the judiciary that stock market prices are the one realistic measure of value, and that the only way to tell how an investor is doing is by valuing his securities portfolio from time to time, even daily, based on stock market prices. Common sense tells us that this approach heavily distorts the facts of life because market prices are considerably less important to some security holders and some companies than they are to others. Market performance as a gauge of how an investor is doing deserves 100 percent weight when: the particular investor does not know anything about the company in which he is investing, when the investor’s financial and/or personal position is such that he is vitally affected, or he believes he is vitally affected, by short-term market fluctuations, for sudden death securities; that is, issues where at a certain date, key events will occur as when an option expires, a tender offer concludes, or a merger transaction is consummated. In most other cases market performance deserves less than a 100 percent weight. Factors affecting how much weight to attach to market performance include the character of the portfolio of securities, whether one looks at the performance of a portfolio or an individual security, who the holder of the security is and what types of bailouts the holder of the security has available.
* This chapter contains original material and parts of the chapter are based on material contained in Chapter 3 of The Aggressive Conservative Investor by Martin J. Whitman and Martin Shubik (© 2006 by Martin J. Whitman and Martin Shubik). This material is reproduced with permission of John Wiley & Sons, Inc.
1 Weinberger vs. UOP, Inc., 457 A.2d 701 (Del. 1983).
2 For example, see G. M. Loeb, The Battle for Investment Survival (New York: Simon & Schuster, 1965), p. 57: “Losses must always be ‘cut.’ They must be cut quickly long before they become of any financial consequence. . . . Cutting losses is the one and only rule of the markets that can be taught with the assurance that it is always the correct thing to do.”
3 The approach is covered in Chapter 15.
4 Myron Scholes, “Professional Measurement—Past, Present and Future,” Evaluation and Management of Investment Performance (Charlottesville, VA: The Financial Analysts Research Foundation, 1977).